Background
On August 25 2016, the Securities and Exchange Commission (the "SEC") adopted amendments to Form ADV and Rules 204-2(a)(7) and (a)(16). The amendments to Investment Advisers Act Rule 204-2 will require advisers to maintain additional records related to the calculation and distribution of performance information. The purpose of the new performance record-keeping requirement is to enable SEC examiners to evaluate adviser performance claims in client communications.
Summary of Changes
The amendments to Rule 204-2(a)(16) will require advisers to maintain records supporting performance claims in communications that are distributed or circulated to any single person, directly or indirectly, instead of the original criteria of ten or more persons.
The amendments to Rule 204-2(a)(7) will require advisers to maintain originals of all written communications received and copies of written communications sent by an investment adviser relating to the performance or rate of return of any managed accounts or securities recommendations.
Concern Over Preservation of Records for Litigation
One of the drivers for the rule change was the case In the Matter of Michael R. Pelosi. Mr. Pelosi was charged with overstating his clients’ portfolio performance returns in quarterly and annual letters. Mr. Pelosi was then fined $60,000 and barred from associating with an investment company or investment adviser. Mr. Pelosi appealed the ruling, which was ultimately dismissed by the Commission because the record lacked an evidentiary basis from which to determine that the performance information was materially false or misleading. This outcome demonstrated to the SEC the disadvantages of not requiring investment advisers to maintain records forming the basis of performance calculations or performance communications.
Effective Date
The compliance date for the above is October 1, 2017. Therefore, any performance information provided to clients after that date must comply with the new records retention requirements.
How will this affect you?
These amendments will have a significant impact on those firms that provide performance information to clients. This would include performance data distributed directly by an adviser through periodic statements or other client communications, or distributed indirectly by the adviser through the firm’s custodian, broker-dealer or other third party on the advisor’s behalf.
Note that Rule 204-2(a)(16) provides that “with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client's account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.” For example, if you send one client a monthly report which shows the account performance since inception 10 years ago, you would be responsible for retaining the backup documentation and performance data calculations for that 10-year performance period plus 5 years from the date of production. The concern for investment advisers will be ensuring access to the information for the required time period. If you rely on a third party for the performance calculation data, can the firm guarantee access to that data during the requisite time period? If not, the firm would need to download and archive the calculation data or otherwise separately maintain it in order to produce it when requested.
Reliance on third parties brings up additional concerns. Note that the rule refers to distributing performance data directly OR indirectly. If you are relying on a third party aggregator or performance reporting from a third party fund manager, you now must have access to their calculation records in order to be in full compliance with the rule change. For example, having a link on your website referring clients to the aggregator’s website for performance data could be seen as “indirectly” providing that information to your clients. (See SEC No-Action Letter for Salomon Brothers Asset Management Asia Pacific Limited and SEC Press Release on F-Square enforcement action, links at bottom of page.)
There are couple ways to approach the record retention requirements when relying on a third party:
- Hire the Third Party Aggregator or Third Party Manager as a service provider. Ensure your contract includes provisions for the third party to maintain the calculation records in compliance with the rule and that you will have ongoing access to those records for the requisite period of time. Conduct periodic due diligence to ensure compliance.
- Contract the Third Party Aggregator or Third Party Manager to send you their performance data on a regular basis or provide access so you may download and keep the calculation records per your own record retention policies and procedures.
Conclusion
In light of the new performance record-keeping requirements, investment advisers may want reconsider whether to include performance reporting in client reports, or possibly, reduce the time-frame the performance period covers. Firms directly or indirectly distributing performance information and relying on third parties for performance calculation data should ensure access to the data during the retention period or should independently maintain the data as part of the firm’s books and records.
Reference Material
Form ADV and Investment Advisers Act Rule – Proposed Rule: https://www.sec.gov/rules/proposed/2015/ia-4091.pdf
Form ADV and Investment Advisers Act Rules - Final Rule: https://www.sec.gov/rules/final/2016/ia-4509.pdf
In the Matter of Michael R. Pelosi – Opinion of the Commission - https://www.sec.gov/litigation/opinions/2014/ia-3805.pdf
Salomon Brothers Asset Management Asia Pacific Limited No Action Letter - https://www.sec.gov/divisions/investment/noaction/1999/salomonbrothers072399.pdf
F-Squared Enforcement Action Press Release - https://www.sec.gov/news/pressrelease/2014-289.html
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